If inflation keeps falling, buy more bonds: Fed's Bullard

President and CEO of the Federal Reserve Bank of St. Louis James Bullard poses during an interview at the Federal Reserve Bank of St. Louis June 8, 2011. REUTERS/Peter Newcomb

NEW YORK (Reuters) - The Federal Reserve should buy bonds if inflation continues to fall, a top Fed official said on Wednesday, stressing the U.S. central bank needs to prevent inflation from being too far below its target.

Still, St. Louis Fed President James Bullard cautioned that more monetary policy accommodation is not yet needed and said he does not currently fear deflation.

“If inflation continues to go down, I would be willing to increase the pace of purchases,” Bullard told reporters after a speech at the Hyman P. Minsky Conference in New York.

The comments from Bullard, a pragmatic centrist and a voting member of the Fed’s policy committee this year, provide an interesting twist to a policy debate that has recently been focused on what level of improvement in the labor market would prompt the central bank to dial down its $85 billion in monthly asset purchases.

The Fed has an official 2-percent inflation target and has said it will keep benchmark interest rates near zero until unemployment falls to at least 6.5 percent, as long as inflation expectations do not breach 2.5 percent.

“I‘m very willing to defend the inflation target from the low side. If we say 2 percent, we should hit 2 percent,” Bullard said.

The Fed’s preferred measure of inflation, the Personal Consumption Expenditures or PCE rate, is around 1.3 percent and is not expected to rise much over the next two years, in large part because of the droves of Americans who are unemployed.

“If it doesn’t start to turn around here soon, I think we’ll have to rethink where we are on the policy,” said Bullard.

In the past, Bullard has talked about tapering bond purchases based on where the unemployment level stands.

Asked about this, Bullard said his stance on inflation is in line with that thinking because part of that analysis was watching how far inflation drifts from the central bank’s target, which was made official last year.

The Fed is currently buying $45 billion in Treasuries and another $40 billion in mortgage-backed securities through the latest round of quantitative easing, known as “QE3”, as it tries to bolster the economic recovery.

The central bank has said it will continue buying bonds until the outlook on jobs improves substantially. Financial markets have started to turn their attention to how long purchases might go on.

Ward McCarthy, chief financial economist at Jefferies, sent a note to clients following the comments that read: “So much for tapering ... upsizing may be in order.”

Bullard said he would prefer to ramp the easing up if needed by buying Treasuries rather than mortgage-backed securities, in part because the Fed should aim to have only government bonds in its portfolio in the longer term.

A different measure of inflation, the consumer price index, showed on Tuesday that prices fell last month.

In his speech, Bullard said the Fed should remain focused on inflation and resist putting more weight on the employment part of its dual mandate.

Unlike most central banks in the developed world, the Fed is tasked with both maintaining price stability and achieving full employment. Since the deep recession, it has eased monetary policy to unprecedented levels to lower the unemployment rate, which last month was 7.6 percent.

“People have been focusing on employment a lot, but have maybe gotten a little bit blinded about the inflation numbers that have come in very low,” Bullard told reporters.

At the same time, he acknowledged it hurts the central bank’s credibility to look past headline inflation in favor of so-called core inflation, which strips out volatile items food and gasoline. He said doing so creates a disconnect between Main Street and policymakers.